(Adds more analyst comments)
By John Parry
NEW YORK, Sept 25 (Reuters) - The U.S. commercial paper market shrank dramatically, marking the biggest weekly contraction in a year, Federal Reserve data showed on Thursday, as the escalating global credit crisis shook investors' confidence in all but the safest instruments issued by the U.S. government.
The swift erosion of this cornerstone of short term lending for banks and companies is a canary in a coalmine for the economy, analysts said. Unless lending to companies and banks can flow freely again, and soon, the economy could grind to a standstill, analysts said.
For the week ended Sept. 24, the size of the U.S. commercial paper market, a vital source of short-term funding for daily operations at many companies, shrank by $61.0 billion to $1.702 trillion, the lowest level since early 2006 and down from $1.763 trillion the previous week, Federal Reserve data showed.
"The declines add to the urgency for fixes to the credit crisis," wrote Tony Crescenzi, chief bond market strategist with Miller, Tabak & Co. in New York in an email note.
Financial markets are on tenterhooks to see if the U.S. government's planned massive bailout legislation for the financial system gets passed and in what form.
The commercial paper data "adds impetus to get the bill approved in its nearly complete form," said Kenneth Kim, economist with Stone & McCarthy Research Associates, in Princeton, New Jersey.
The erosion of the commercial paper market is "a manifestation of the credit crunch's self-reinforcing impact on the U.S. economy," Kim added.
The market's cumulative shrinkage is more than $100 billion in just two weeks, including the previous week's $52.1 billion fall.
Analysts agree that the commercial paper market, along with most other conduits of short-term borrowing for banks and companies, has become effectively paralyzed over the past week.
Unsecured issuance by financial firms plunged by $50.3 billion in the latest week, the biggest weekly fall since at least 2001, after declining by $16.9 billion the previous week.
When the credit crisis started to unfold last summer, the key area of weakness within commercial paper was mortgage-related asset backed instruments tied to the already declining U.S housing market. But now, the sag in issuance by financial firms is a sign that the whole commercial paper part is succumbing to broad lending markets stress and endangers the the whole economy, analysts said.
"These declines in some ways carry more weight than those of a year ago, when the market was purging issuers with mortgage-related exposures," wrote Crescenzi. "This time the purge is broad and is impacting issuers with far more predictable cash flows--regular run-of-the-mill companies in need of working capital," he wrote.
As the global credit crisis deepens, banks' distrust of lending to each other has worsened in interbank markets, with many hoarding cash for fear that some short-term loans might not get repaid. A similar dynamic is roiling the commercial paper market, analysts say.
Money market funds have diverted hefty amounts out of commercial paper and other non-government instruments into the ultra-safe haven of Treasury bills, after a money market mutual fund broke the buck, or fell below $1 per share value last week, triggering investor fears about the safety of short-term paper from banks, insurers and companies.
"The declines reflect the seizing up of the credit market and withdrawals of monies from money market funds, which held $700 billion of commercial paper at the end of the second quarter," wrote Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co. in New York in an email note.
Asset-backed commercial paper outstanding fell $7.8 billion after falling $18.6 billion the previous week.
U.S. asset-backed commercial paper outstanding slipped to a total $753.8 billion in the latest week from $761.6 billion the previous week. (Reporting by John Parry; Editing by Chizu Nomiyama)